CA.CS.CMA.MBA: Naveen.

Rohatgi

TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
UNIT 3 : RISK MANAGEMENT AND DERIVATIVES
Meaning of Risk management : Foreign exchange risk is the exposure of a companys
financial strength to the potential impact of movements in foreign exchange rates. The risk is that
adverse fluctuations in exchange rates may result in a reduction in measures of financial strength.
It is acknowledged that specific foreign exchange risk practices may differ among banks
depending upon factors such as the institutions size, and the nature and complexity of its
activities. However, a comprehensive foreign exchange risk programme should deal with, at a
minimum, good management information systems, contingency planning and other managerial
and analytical techniques.
RISK FACED BY CORPORATE BY ENTITY :
1. Transaction Risk : The exchange rate risk associated with the time delay between
entering into a contract and settling it. The greater the time differential between the entrance
and settlement of the contract, the greater the transaction risk, because there is more time
for the two exchange rates to fluctuate.
Transaction risk creates difficulties for individuals and corporations dealing in different
currencies, as exchange rates can fluctuate significantly over a short period of time. This
volatility is usually reduced, or hedged, by entering into currency swaps and other similar
securities.
2. Translation Risk: The exchange rate risk associated with companies that deal in foreign
currencies or list foreign assets on their balance sheets. The greater the proportion of asset,
liability and equity classes denominated in a foreign currency, the greater the translation
risk.
This poses a serious threat for companies conducting business in foreign markets.
Exchange rates usually change between quarterly financial statements, causing significant
variances between the reported figures. Companies attempt to minimize these transaction
risks by purchasing currency swaps or hedging through futures contracts.
3. Economic Risk: Generally speaking, economic risk can be described as the likelihood that
an investment will be affected by macroeconomic conditions such as government regulation,
exchange rates, or political stability, most commonly one in a foreign country. In other words,
while financing a project, the risk that the output of the project will not produce adequate
revenues for covering operating costs and repaying the debt obligations.

CA.CS.CMA.MBA: Naveen. Rohatgi

TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
In a nutshell, economic risk refers to the risk that a venture will be economically unsustainable,
due to various reasons vitiating from an alteration in economic trends to fraudulent activities
which ruin a projects outcome. Before starting with the projects, it is important to consider
economic risk for determining the likelihood of potential risks being outweighed by the benefits.
RISK FACED BY COMMERCIAL BANK:
1. Transaction Risk: The exchange rate risk associated with the time delay between
entering into a contract and settling it. The greater the time differential between the entrance
and settlement of the contract, the greater the transaction risk, because there is more time
for the two exchange rates to fluctuate.
Transaction risk creates difficulties for individuals and corporations dealing in different
currencies, as exchange rates can fluctuate significantly over a short period of time. This
volatility is usually reduced, or hedged, by entering into currency swaps and other similar
securities.

2. Position Risk: Positions, dealers deliberately do not covers transaction in anticipation of

favorable rate movement thereby converting a normal business transaction into transaction. This
action is called creating an Open position. Any adverse development resulting in a loss treated
as position risk.
If the open position is created by buying foreign currency, it is called over- bought or long
position, whereas if the position is created by selling foreign currency, it is called oversold or
short position. The maximum amount up- to- which an open position can be created is called
Day- light limit. This limit he signifies the total exposure which the bank is willing to accept on
behalf of the dealer.
3. Settlement Risk: Banks contract with each other and with customers for various forward
maturities. Such contracts being over the counter (OTC) contracts, they carry a credit risk for
both parties. If a counter party fails, i. e. becomes bankrupt or otherwise incapable of fulfilling
the contract, on any day from the contract date up- to one day before the settlement date, then the
other party is required to replace the counterparty with a third party. The replacement contract
rate may be adverse as compared as compared to the original contract rate. Such a loss which
represents the cost of counterparty replacement is called pre- settlement risk.
4. Pre settlement Risk: On the day of settlement, if on of the parties to the contract fails after
the other party has delivered under the contract, then in addition to the loss of the principle, the
other party would also face the cost of counterparty replacement and minimum one days

CA.CS.CMA.MBA: Naveen. Rohatgi

TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
overdue interest. This is because corrective action can be taken only after cash transaction
timing. Settlement day risk occurs due to time zone factors and may exceed the principal value
of contract. (this risk attracted greater attention of risk managers after the Bank Herstatt case of
1974 )
Both pre- settlement and settlement risks are controlled through setting up of global counter
party limit for all forward transactions. Within this global limit, a small sub- limit is fixed for per
day exposure for a given forward maturity. This no there is no concentration of exposure to any
counterparty for a specific maturity
MEANING OF HEDGING:
A hedge is an investment position intended to offset potential losses/gains that may be incurred
by a companion investment. In simple language, a hedge is used to reduce any substantial
losses/gains suffered by an individual or an organization.
A hedge can be constructed from many types of financial instruments,
including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many
types of over-the-counter and derivative products, and futures contracts
Meaning of Derivatives: A security whose price is dependent upon or derived from one or more
underlying assets. The derivative itself is merely a contract between two or more parties. Its
value is determined by fluctuations in the underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market indexes. Most
derivatives are characterized by high leverage.
Derivatives are generally used as an instrument to hedge risk, but can also be used for
speculative purposes. For example, a European investor purchasing shares of an American
company off of an American exchange (using U.S. dollars to do so) would be exposed to
exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase
currency futures to lock in a specified exchange rate for the future stock sale and currency
conversion
back
into
Euros.
FOREIGN CURRENCY FORWARD CONTRACT:
A foreign currency forward contract can be described as on over- the counter agreement
between two parties in which they agree to exchange a definite amount of foreign currency at an
agreed conversion rate either on a fixed future date or during a fixed future date or during a fixed
future period.
In India, in all such contracts, one party is always an authorized dealer. The other party to the
contract may be a customer of the bank or another authorized dealer.

CA.CS.CMA.MBA: Naveen. Rohatgi

TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833

Characteristic features of foreign currency forward contracts:

1. These contracts represent privately arranged agreements which are therefore negotiated

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on over the counter (OTC) basis. These contracts are highly flexible and can be
structured according to the requirements of the concerned parties.
Such contracts are customized contracts, both in terms of amount and maturity, and thus
provide a means of achieving 100% hedge.
Banks normally do not demand any margin money and hence there is no interest cost.
There is a commitment to exchange specified currency at an agreed price in future. This
means that delivery is mandatory and takes place at maturity on contracted terms.
If the spot price on the maturity date exceeds the contract price, the forward buyer stands
to gain. The gain will be equal to spot market price minus contract price. If the spot price
on maturity date is below the contract price, he incurs a loss. The gain/ loss of the
forward buyer is equal to the loss/ gain of the forward seller which means the riskreward profiles are symmetrical. This is known as Linearity.
Delivery under such contracts is compulsory and it is not possible to set- off forward
purchases against forward sales. This mean it is not possible to trade in such contracts.
However contracts can be cancelled. Such cancellations are required to be done with the
same counter party.
Both parties to the contract are exposed to credit risk i.e: the possibility of counterparty
failure in fulfilling contractual liabilities.
Profit or loss on forward contracts gets crystallized only on maturity. There in no Mark
to Market concept in forward contracts.
These are bilateral contracts with no brokers or intermediaries involved and therefore
there are no overhead expenses.
Under- utilization, non- utilization or late utilization of the contract leads to cancellation
of contract on maturity at customers cost.

FOREIGN CURRENCY FUTURE CONTRACT

A futures contract can be defined as an agreement between the buyer and the seller,
standardized in regard to both amount and maturity, settled through an organized exchange,
in terms of which the seller is obliged to deliver a specified currency to the buyer on a
specified date and the buyer is obligated to pay the seller the contracted price in exchange for
the delivery of the currency.

CA.CS.CMA.MBA: Naveen. Rohatgi

TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
FEATURES:
1. These contracts are standardized both in terms of contract value and maturity.
2. Since real time contract values are customized, use of futures does not always provide
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100% hedging.
A special characteristic of such contracts is the elimination of credit or counterparty risk.
The clearing house associated with the exchange provides a settlement guarantee to both
buyers and sellers by acting as counterparty for both participants.
The clearing house protects itself through margin money recovered from both buyers and
sellers. In futures contracts both participants are obligated to perform their part in the
contract.
The margin money is recovered through designated brokers through whom all futures
contracts are undertaken. This means that these contracts involve overhead expenses by
way of brokerage and margin money cost.
Both purchase and sale contracts, are Marked to Market at the closing price of the
trading day, thereby crystallizing the profit/ loss daily. This amount is credited/ debited to
the margin money account. The futures contract can thus be viewed as a series of forward
contracts in sequence for the same amount and maturity date.
It is not necessary to hold such contracts to maturity. They enjoy the right of set- off
which means that purchase and sale contracts cancel each other. This allows participants
to benefit from rate movements. These contracts are therefore trade- able.
Since opposing contracts are eligible to be set off against each other they can be easily
reversed/ cancelled. In all cases the clearing house is the common counterparty. Therefore
only the cash difference needs to be exchanged on settlement.

MEANING OF CURRENCY SWAPS:

A currency swap involves two parties that exchange a notional principal with one another in
order to gain exposure to a desired currency. Following the initial notional exchange, periodic
cash
flows
are
exchanged
in
the
appropriate
currency.
An American multinational company (Company A) may wish to expand its operations into
Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S.
market. Financial problems that Company A will typically face stem from Brazilian banks'
unwillingness to extend loans to international corporations. Therefore, in order to take out a loan
in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will
not be able to attain a loan with a favorable interest rate in the U.S. market. The Brazilian
Company may only be able to obtain credit at 9%.
While the cost of borrowing in the international market is unreasonably high, both of these
companies have a competitive advantage for taking out loans from their domestic banks.
Company A could hypothetically take out a loan from an American bank at 4% and Company B
can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is
due to the partnerships and ongoing relations that domestic companies usually have with their
local lending authorities.
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CA.CS.CMA.MBA: Naveen. Rohatgi

TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
OPTIONS:
An option is a derivative instrument which given the buyer the right but not the obligation to buy
or sell specified amount of foreign currency on or before a standardized future maturity date at a
pre- decided strike price (also called exercise price). The buyer of the option pays a specific
premium to the seller for getting the right. This represents the consideration for the contract.
CLASSIFICATION OF OPTION CONTRACTS:
Options which provides the buyer with the right to buy the specified foreign currency are called
Call Options whereas contracts which provide the buyer the right to sell the specified foreign
currency are called Put Options.
Option contracts which can be exercised on any date up- to the maturity date are called
American options whereas contracts which can exercised only on the maturity date are called
European options. Both these types of options are used in India and contracts maturing in a
particular calendar month are settled on the last working day of the calendar month.
SPECIAL FEATURES:
An option contract can thus be viewed as a combination of two contracts:
a) An agreement between the buyer and seller involving transfer of a right for which consideration
by way of premium is paid by the buyer to the seller, and
b) On exercising the right the buyer of the option is entitled to either buy or sell specific amount of
currency at a pre- decided strike price which represents consideration for the transaction.
OPTION PRICE

Option price is the cost, which the option buyer pays to the option seller. It is also called
premium. Premium is the price that the buyer of an option, whether call or put, pays to the writer
of the option, for acquiring the rights conveyed by the option. The premium of the option is a
function of variable, such as:
Current currency price, (spot/ cash market value)
Strike price, (exercise value)
Time to expiration, (contract date to expiry)
Volatility of the currency, and
Interest rates. (of foreign and domestic currencies)
The buyer pays the premium to the seller, which belongs to the seller whether the option is
exercised or not. If the buyer of an option decides not to exercise the option, the option writer
retains the premium but if the option is exercised, the premium gets adjusted against the loss that
the writer incurs upon such exercise.
OPTION PRICING:

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TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
INTRINSIC VALUE
The premium payable on an option or the price of an option is made up of two components,
namely, intrinsic value and time value. Intrinsic value is also called as Parity value.
For an option, the intrinsic value is to the amount by which it is in money. Therefore, an option,
which is out- of the money or at- the money, has no intrinsic value.
9.11 DISTINCTION
NO
FUTURES CONTRACTS
OPTION CONTRACTS
01
Both buyers and sellers are subject toBoth buyers and sellers are subject to
symmetrical obligations.
asymmetrical obligations
02
Delivery of underlying asset is mandatory. Delivery of underlying asset is optional.
03
Performance commitment is implied in theThe contract needs to be specifically
contract.
exercised or lapses on maturity.
04
These contracts are only traded onThese contracts may be traded both on
exchanges.
exchanges or on OTC basis.
05
Difference between contract and spot priceFavourable difference between contract and
represents time value/ cost of carry.
spot market price represents intrinsic value.
06
Involves payment of consideration only onInvolves payment of premium for purchasing
delivery.
the contract and exchange of consideration if
the contract is exercised.
07
Delivery can be demanded only onContract may be exercised on any day up to
maturity.
maturity.
08
Trading strategies are restricted to onlyMultiple option trading strategies are
buy/ sell operations.
available based on market view.
09
Both buyer and sellers are subject to dailyOnly seller (option writers) are subject to
mark- to- market.
daily mark-to- market since they are exposed
to unlimited losses.
9.12 DISTINCTION BETWEEN FORWARDS AND OPTIONS CONTRACTS:
NO
FORWARDS
OPTIONS
1.
A forward contract can be described as anAn option contract can be described as an
agreement between two parties toagreement wherein the buyer acquires a right
exchange a specific quantity of the(without any obligation) from the seller to
underlying on a fixed future date at a pre- either buy or sell a specified quantity of the
decided price.
underlying on a future date at a pre- decided
(strike) price.
2.
Such contracts are privately negotiated onSuch contracts may be on OTC or ETD basis.
OTC basis.
3.
Performance obligation to take or giveThe buyer needs to specifically exercise the
delivery of the underlying is implied for option to demand performance from the
both parties in these contracts.
seller.
4.
the contracts are customized in term ofthe EDT contracts are standardized in terms
quantity, delivery date, asset quality etc. of quantity, delivery date, asset quality etc.
5.
The contracts can mature on any specified In India, capital market ETD options mature
date in the future.
on the last Thursday of the month to which
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CA.CS.CMA.MBA: Naveen. Rohatgi

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NO
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3
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TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
they pertain.
These contracts exhibit symmetricalThese contracts exhibit unsymmetrical
obligations for both the buyer and the obligations. The buyer enjoy the right to
seller and therefore normally there is nodemand performance whereas the seller
up- front payment exchanged between theaccepts the performance obligation in return
parties.
for an up- front consideration in the form of
premium.
The forward price is based on the spot The option price is based on the spot market
market price of the underlying and the price of the underlying and estimated future
cost- of- carry.
trend of the market price. (the two
components are represented by the intrinsic
value and time value of the option)
These contracts can be exercisedIn the case of American options, the contracts
(performance demanded) only on maturitycan be exercised on any day till expiry.
date
Such contracts normally do not involveIn these contract only the seller has a
any margin money deposit.
performance obligation. This means the buyer
can only incur the loss of premium whereas
the seller is exposed to unlimited loss.
Therefore for ETD options only the seller is
required to deposit margin money with the
exchange.
The forward price is bilaterally negotiatedThe option price is publicly declared and falls
and does not fall in the public domain.in the public domain. The price discovery
Thus there is no transparency in pricing of process of such contracts is therefore
such contracts.
transparent.
The profit/ loss of the buyer are equal and The profit/ loss of the buyer are unequal to
opposite to that of the seller. The pay- offthat of the seller. The pay-off is non- linear.
is linear.
These contracts are not tradable.
The ETD options are tradable.
FORWARD CONTRACTS
FUTURES CONTRACTS
A forward contract can be defined as aA futures contract can be defined as a contract
contract between a bank and its customer inbetween an exchange and an operator in which
which the bank agrees to buy/ sell a specific the operator agrees to buy/ sell standardized
amount of foreign currency on a fixed forwardamount of foreign currency for delivery on a
date or within a fixed forward period, at a ratestandard maturity date in the future, at a
decided on the date of the contract.
specified rate.
Forward contracts are customized in terms of Futures contracts are standardized in terms of
amount and settlement date.
amount and settlement date.
Settlement date of a forward contract can beAll futures contracts maturing in a particular
any forward date.
calendar month are settled on the last working
day of the month in India.
A forward contract can provide 100% hedge toFutures contract do not provide 100% hedge
the customer.
to the operator.
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CA.CS.CMA.MBA: Naveen. Rohatgi

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TYBFM: Foreign exchange Market

RN TUTORIALS: 9867451833
A forward contract is a rigid transaction whoseA futures contract is a flexible instrument
terms cannot be changed except with thewhich can be cancelled through an opposite
original counterparty.
transaction with the exchange.
Both parties to a forward contract carry creditFutures contracts do not involve credit risks
risk.
because for both buyers and sellers, the
counter party is the exchange which
guarantees the transaction. This is called the
Principle of Novation.
A forward contract normally does not involveFuture contract involves maintenance of initial
payment of any margin money deposit.and minimum margins with the exchange. All
Therefore there is no cost of funds.
futures contracts are marked- to market on a
daily basis by corresponding debit or credit to
the margin money account. If balance of this
account falls below the minimum margin
level, then the operator is called upon to
restore the margin money account up to the
initial margin level.